China’s predicted stumble

The plummet in the China stock market was foreseeable a year ago

Ray Zinn, Founder of Micrel

You have likely heard the news that despite economic stimulus, the Shanghai stock exchange dropped over 7% before “circuit breakers” kicked in. Had those government-mandated panic aversion tools not triggered, the one day drop would rival long-term market corrections. None of this, aside from the exact timing, was a surprise.

Most of China’s economic growth has been tied to manufacturing in the high tech sector. This includes consumption of semiconductors, an industry where my company Micrel thrived for 37 years. As you might expect, when China’s manufacturing outlook changes, it is felt in the semiconductor business. Since nearly 60% of Micrel’s semiconductor content was sold into Asia, with at least half of that going to China, slow-downs on our sales books foreshadowed changes for China. When initial ripples did not reverse course, one could predict what we saw today – confirmation that China’s manufacturing sector had peaked.

Normally, the manufacturing index for a country fluctuates, but rarely shows a consistent decline over an extended period. Last summer the Chinese stock exchanges tumbled when their manufacturing index showed contraction for several straight months. People held out hope that the situation would reverse itself as the Chinese government poured money into the economy and attempted to stimulate consumer spending (the United States, despite having its own manufacturing slump, is surviving the 2016 stock slide better thanks in part to a fully-formed consumer economy striding alongside of improved employment and rising wages).

China is different. China became an electronics manufacturing country in the wake of the dot-com bust. After 2001, many large OEM companies sold off their manufacturing operations or shut them down. China stepped in and ramped-up their contract semiconductor manufacturing. Driven by the low cost of manufacturing in China, they began a rapid development of electronic manufacturing as well. China is today the largest manufacturer of electronic systems in the world – an outsized portion of their overall economy.

China's goal is to be a primary supplier of electronic systems (recall that IBM sold off its personal computer division to Lenovo, a Chinese company). It is also their intent is to have the majority of their semiconductor content manufactured within China. This creates a precarious situation. With roughly half the cost of an electronic system being semiconductor components, a great deal of China’s economic growth has been tied to a relatively small part of the world economy.

When that one piece – electronic systems – became saturated, growth halted then began contraction. I saw it a year ago in the semiconductor business. As the China Purchasing Managers' Index (PMI) shows, the contraction began in March of 2015. Despite momentary improvements, the economic contraction continues.

Part of the problem is over-capacity. There was an all-too-rapid buildup of electronic system manufacturing within the country of China. It was an uncontrolled expansion, fueled in no small part by economic intervention by the Chinese government. This rush to fulfill demand for electronics systems did not take into account that the United States, the largest consumer of such products, was slow to recover from their own Great Recession. This lack of growth in the U.S. exacerbated China’s overcapacity.

I predict it will take another two to three years to normalize the capacity/demand ratio. I sense that there is approximately a 30% overcapacity rate in China. With a lack of economic growth in the U.S. and sluggish growth worldwide, and with certain sectors (e.g. energy) that are heavy users of electronic systems having their own problems, my 2-3 year recovery estimate for China may be optimistic.

This has consequences for America, mainly for the U.S. semiconductor industry. With saturation and overcapacity in China, demand for chips in general will be sluggish. This impacts sales for existing chips, while creating a lackluster demand for new designs and an overall malaise in the industry. Some semiconductor companies that have been on acquisition sprees will find their top-line revenues stunted and they may be unable to service debt acquired for recent acquisitions. Oddly, this may lead to stock price crashes and even larger scale consolidation in the industry.

Some U.S. companies, like Apple and Cisco, will benefit. With slumping sales and low prospects, and with some semiconductor manufacturing in other countries, China will feel pricing pressure. The raw materials for today’s off-the-shelf hardware systems will drop. Since these end products are not that price sensitive, it will likely incrementally improve product margins.

The key points though are that we saw this coming. Artificial economic growth is unsustainable. Relying too heavily on any single industry is a hazard for a national economy and for investors. The resulting problems will require years to mend.